ECONOMIC STUDIES DEPARTMENT OF ECONOMICS
SCHOOL OF BUSINESS, ECONOMICS AND LAW UNIVERSITY OF GOTHENBURG
188
________________________
Formal and Informal Regulations:
Enforcement and Compliance
Clara Villegas Palacio
ISBN 978-91-85169-48-1 ISSN 1651-4289 print
ISSN 1651-4297 online Printed in Sweden, Geson Hylte Tryck 2010
A los míos
Table of contents Preface
Abstracts Introduction
Chapter 1: On the interaction between imperfect compliance and technology Adoption: Taxes v. Tradable Emissions Permits
1. Introduction ……… 2
2. The model ……….. 4
3. Compliance behavior and technological adoption…….. 7
4. Monitoring probability and the effects on technology adoption……… 13
5. Conclusions………. 19
References Appendix A Appendix B Appendix C Appendix D Chapter 2: Targeted enforcement and aggregate emissions with uniform emission taxes 1. Introduction ……….. 2
2. The problem of the firm ……… 5
3. The model of adoption ……….. 12
4. Targeted enforcement and aggregate emissions …….... 15
5. The problem of the regulator ………. 19
6. Conclusions ……… 23
References Appendix A Appendix B Chapter 3: Unraveling enforcement: on the substitutability of detection and enforcement efforts 1. Introduction ……….. 2
2. Firm behavior under imperfect monitoring and enforcement ………...…… 5
3. Experimental design and procedures……….. 14
4. Results……….…….... 19
5. Conclusion………. ………. 27 References
Appendix A
Chapter 4: Does disclosure crowd out cooperation?
1. Introduction ……… 2
2. Experimental design ……….. 6
3. Experimental results ……….. 9
4. Discussion and conclusions ………... 19
References Chapter 5: Conditional cooperation and social group – Experimental Results from Colombia- 1. Introduction ……… 2
2. Experimental design and procedure ………... 3
3. Results ……… 4
4. Conclusion ………. 8 References
Preface - Gracias
When you are born and raised in Colombia, the first word your parents teach you is
“GRACIAS”. Now that four years have passed and that the end of the “pre-yellow book era”
is here, it is time for me to practice my parents’ first lesson and say gracias to those who have made my PhD studies not only a possible but a pleasant experience. First of all, I will never be able to thank God enough for all He has given me through my life. He has always been next to me “with countless gifts of love”. Now, it is definitely time to look up to the sky once more and say MUCHAS GRACIAS.
To my supervisors Peter Martinsson and Thomas Sterner: MUCHAS GRACIAS. Peter has always been enthusiastic, supportive and encouraging. I always knew I could knock on his door or send a “nudge” over MSN or Skype and he would be available to say “Hola, cómo estás? ” and to talk about what I needed. He always kept track of every stage of my thesis and was willing to help with everything. I am deeply grateful for his solidarity and support when, close to an important deadline, I lost one of my beloved family members in Colombia.
Gracias for everything Peter!. Thomas has been an important support; he provided insightful comments on chapters of this dissertation that made me think of real applications of my research questions. Many times he helped me answering the question of “how does this work in reality?”. From him I admire his intellectual skills but also, and perhaps more important, his friendly temper and his way of seeing life as a colorful experience. Gracias for everything Thomas, including your Spanish!!!
I am indebted to Jessica Coria. I have benefited a lot from academic discussions with Jessica and have learnt a lot from her. She has been very close and helpful during the process of writing my thesis. But she is not only my coauthor; she is my very good friend. Our discussions about life, about the “Latin - Swedish cultures fusion”, all our attempts to understand and/or interpret “Swedish codes” and our theories about “intercultural relationships” are things I will never forget. Not to mention our “tapas” evenings, our drawer full of chocolates and cookies, our coffee machine and the coffee-chocolate breaks that made many tough days easier. Gracias Jessica for your company, for your help and for your friendship. I will miss you!.
I also want to express my deep gratitude to Katarina Nordblom. She read very carefully several versions of almost all of my papers and always provided very good, constructive, detailed and helpful comments. She kept her door open and was always available to help me.
Gracias Katarina for your help, I owe you!!.
I would like to thank Miguel Angel Quiroga, Jorge Dresdner, Carlos Chávez and Marcela Jaime, from Universidad de Concepción in Chile for encouraging me to apply to the PhD program in Gothenburg. Gracias for trusting and supporting me, I hope I did not disappoint you. All my gratitude also goes to the academic staff at the Economics Department in the University of Gothenburg. Special gracias to Renato Aguilar, Fredrik Carlsson and Åsa Löfgren for the opportunity of being teaching assistant in the mathematics and environmental economics courses; without any doubts, I benefited a lot from it. I am particularly thankful to Fredrik Carlsson, Åsa Löfgren, Olof Johansson-Stenman, Katarina Nordblom, Oleg Shchetinin, Jessica Coria, Peter Martinsson and Thomas Sterner for their comments on my single authored paper. I also want to thank Renato Aguilar, Carlos Chávez, Håkan Eggert , Magnus Hennlock, Marcela Ibañez, Gunnar Kölin , Katrin Millock, Andreea Mirut, Amrish Patel, Jesper Stage and Matthias Sutter for their support and their comments on some of the chapters in this thesis. My dissertation also benefited from the comments of the external examiners for my Licenciate and final seminar Patrick Söderholm and Stefan Ambec.
The administrative staff in the Department was always so diligent and helpful. Gracias to Gerd Georgsson, Jeanette Saldjoughi and Eva-Lena Neth-Johansson for all their help with the, always difficult for me, administrative matters. The first weeks in Sweden would have been especially difficult without the support and help from Elizabeth Földi. Elizabeth made everything easier at that time and since then she has been ready to help when necessary.
Muchas gracias Elizabeth!!
I also owe gratitude to some institutions and people who helped me during the course work and the research part of my PhD . I have great memories next to colleagues and friends in the Environmental Economics Unit, thanks to all for making EEU a great place to pursue PhD studies. Gracias to The Swedish International Development Agency SIDA for the financial support of my studies and for the program of capacity building in developing countries.
Gracias to the Universidad Nacional de Colombia- Sede Medellín, and in particular, to my colleges and friends at Escuela de Geociencias y Medio Ambiente in the Engineering Faculty and at Instituto de Estudios Ambientales for their support during my “comisión de estudios”.
Gracias to Asociación Nacional de Industriales ANDI-Medellín, Corporación Universitaria Lasallista, Universidad Nacional de Colombia and Escuela de Ingeniería de Antioquia for making our experiments possible. Gracias to Lina María Berrouet and Angela María Gonzalez for their excellent research assistance.
During these four years I had the fortune of having very smart and nice people as my classmates. Eyerusalem, Haoran, Nam, Kofi, Yonas, Qian, Måns, Andreas and Conny have my deep gratitude. I will always remember each one of them with great affection. I really hope that despite of geographical distance we continue being friends. I shared almost all my lunch hours in Gothenburg with Nam, it was great to sit and talk about what Colombia and Vietnam are like. Gracias Nam, I will miss having lunch with you. Marcela Ibañez “la veci”
also helped me with advices, company and support in these four years. I have missed her since she left Gothenbug. Muchas gracias por todo veci!!
Some families have opened the doors of their homes to me during my stay in Gothenburg.
Renato and Patricia were always very welcoming in their place; nunca voy a olvidar la rosa amarilla de García Márquez el día de la defensa de mi licenciatura. Gracias Renato y Patricia!!. Jorge Bonilla, Milena, Jorge Esteban and Juan Manuel made me feel part of their family; next to them I enjoyed many hours of Colombian talking and Colombian food. Por compartir todo eso conmigo, Jorge, patoja y niños, gracias!. To visit Nam and his family was always a pleasure, gracias to him and to Thi for great times in their place. Last but not least, Conny’s family has my sincere gratitude. They have been willing to share their special dates and ordinary days with me. Gracias to them for their hospitality and affection.
I am indebted to two great teachers from previous years. Muchas gracias to Enrique Angel who was my supervisor when I was writing my monograph in Civil engineering. He introduced me to environmental issues. I learnt a lot from him and every time we talk I feel I still have a lot to learn. My special gratitude also goes to Carlos Chávez who was my supervisor during the master in Concepción and who introduced me to enforcement and compliance issues. He has been a great support during my PhD studies. He not only read very carefully some of the chapters in my thesis and provided insightful comments, but also was always willing to hear my worries, helped me and gave me some advices when I needed them. Muchas gracias Carlos!!. Enrique and Carlos have all my respect, admiration and gratitude.
Conny Wollbrant. He has been my colleague, my teacher, my translator, my friend, my support, my company and my love. He was always willing to help with everything I needed.
He knows every detail of my thesis. He gave me back the trust in my work in the moments I lost it. Conny always made me feel that, even being so far away from home, I was not alone in Gothenburg. His love has been unconditional and patient. Hanne, you certainly did a very good job with Conny, he is a great man. Conny, next to you my life in Sweden has been easier and sweeter; gracias to you I got to experience and admire a lot of the Swedish culture and next to you my dark days in Sweden had more light . I will always be in debt with you.
Gracias lombra!!
I count myself as a very lucky person for having “la barrita” as my very close friends since I was a kid. We have stayed together during our ups and downs and I really hope we continue like that. Whenever I come home and meet them I feel I never left. Gracias to Arroyo, Vivi, Tata, Chamo, Pily, Lianis and Angelita for being always with me. Thanks to the husbands of
“la barrita” Johnny and Clifford, for being such a patient guys with 8 women talking at the same time. To have all of you as my friends makes my life happier. Gracias to Lina Berrouet, Lina Vidal and Claudia Aravena for being available to talk to me during my time in Sweden at any time of the day and any day of the week. You were a very good company.
Mónica Pérez and Paula Zapata have been my friends since many years ago, I never felt I was far from you two, Gracias!.
This thesis is dedicated to my loved ones. It would have been very hard for me to be in Sweden if I did not know that I had the support and love of my people at home. I owe everything I am to my family. They are the greatest gift I have received in my life. My parents gave us the best of their lives and with their example taught us that the only valid way of getting what you want in life is with honesty and hard work. As one of my brothers once said, they raised us with the perfect mixture of love and discipline. That is why our achievements are also theirs. I will never be able to give them back what both of them have done for me, DIOS LES PAGUE!!. Gracias to my brothers Sergio, Alejandro and Juan Camilo for being always laughing at ourselves, for being always there to joke and, most important, always being there to support each other. I am so proud of each one of you.
Having you, together with Gloria, Clemencia and Paula gives me the certainty that I will always have a family, GRACIAS. To Lina, my dear primis for being a sister and supporting me in this, GRACIAS!
When I was a child I spent most of the weekends and my vacations in my grandparents place
“donde mamabuela”. Growing up next to my uncles and aunts was a fantastic experience.
Gracias to Carmen, Leonor, Adela, Alcira, Marta, Gonzalo, Alberto Elías, Carlos and Clarita for making it possible to have extraordinary memories from my childhood; for sure they have given me the courage to chase my dreams. Carmen, only you know how much I miss you, GRACIAS por todo. Three of my loved ones passed away while I was in Sweden. I cannot help to feel a deep nostalgia from knowing that they will not be around when I go back home.
I know they would have been very proud and happy for me. Adela, Leonor and Amparo, wherever you are GRACIAS!!!.
To my beloved nieces Mariana, Maria Antonia, Maria Fernanda, Ana Clara and the ones to come; you are in the last sentence of this preface because you are a new beginning. You are the sweet hope of a good future. Gracias, this thesis is also for you.
Clara Inés Villegas Palacio Gothenburg, April 2010.
Abstract
The question I address in the thesis is how cooperation in social dilemma situations and compliance with environmental regulations are determined by legal enforcement, intrinsic motivations and culture. In light of this, the thesis consists of five independent chapters.
Chapter 1 analyzes the effects of the interaction between technology adoption and incomplete enforcement on the extent of violations and the rate of abatement technology adoption. We focus on price-based and quantity-based emission regulations. First, we show that in contrast to uniform taxes, under tradable emissions permits (TEPs), the fall in permit price produced by technology adoption reduces the benefits of violating the environmental regulation at the margin and leads firms to modify their compliance behavior. Second, we show that the regulator may speed up the diffusion of new technologies by increasing the stringency of the enforcement strategy in the case of TEPs while in the case of uniform taxes, the rate of adoption does not depend on the enforcement parameters.
In Chapter 2, I study the effects of targeted monitoring strategies on the adoption of a new abatement technology and, consequently, on the aggregate emissions level when firms are regulated with uniform taxes. My results suggest that a regulator aiming to stimulate technology adoption should decrease the adopters’ monitoring probability and/or increase the non-adopters’ monitoring probability. In contrast to previous literature, I find that, in some cases, a regulator whose objective is to minimize aggregate emissions should exert a stronger monitoring pressure on firms with higher abatement costs.
In some contexts, weak law enforcement results in only a fraction of detected transgressors actually being sanctioned. The standard theoretical models of enforcement predict that, as long as the joint probability of detection and sanction is constant, the extent of violations does not vary with different combinations of the probability of monitoring and the probability of sanction given detection. In contrast, in Chapter 3 we propose an alternative theoretical model that predicts that the extent of violation is sensitive to such combinations, i.e., these two probabilities are not perfect substitutes. By using a laboratory experiment, we investigate the hypothesis of imperfect substitutability of monitoring and sanctioning probabilities. Our subjects include both environmental managers in Colombian firms and university students.
Different combination of the probabilities resulting in the same joint probability of detection and sanctioning did not affect the violation behavior among managers, while students violate relatively less when facing a higher sanctioning probability for a given joint probability.
Chapter 4 investigates whether disclosure crowds out pro-social behavior using a public goods experiment. In a between-subject design, we investigate different degrees of disclosure.
We find a small positive but insignificant effect of disclosure treatments on contributions to the public good. Thus, our empirical findings are consistent crowding-out theory.
In contrast to previous studies on cross-group comparisons of conditional cooperation, in Chapter 5 we keep cross- and within-country characteristics constant. The results reveal significantly different cooperation behavior between social groups in the same location.
Introduction
Given its characteristics, environmental quality can be considered a public good.
With increasing recognition of the significance of environmental protection, a large number of policy instruments have been designed to regulate pollution in hopes to achieve the desired levels of this public good. Among these instruments are economic incentives such as environmental taxes and marketable emission permits. In several cases, the design of such policies gives them a social dilemma character where regulated agents have a clear incentive not to cooperate by not complying with the regulation. If nobody complies, however, then everybody is worse off than if they had cooperated by complying.1 Sociological research has examined the role of three factors in shaping compliance with laws: the threat of sanctions, the opinions of peers, and personal morality (Tyler, 2006a). Analogously, Bénabou and Tirole (2006) and Ariely et al. (2009) discuss the role that external motivations such as rewards or punishments, intrinsic motivations such as altruism, and image motivations have on pro-social behavior of individuals.
Compliance with legal requirements and cooperation in a social dilemma situations are then determined by the coexistence and interaction between three regulatory systems (Mockus, 1994). First, is the legal system, which we refer to as formal regulation. This is defined by a set of laws together with enforcement mechanisms such as monitoring and legal punishment of transgressors. Enforcement mechanisms are oriented to promote compliance with the law and to avoid actions beyond what is legally allowed. The second and third among these systems are morale and culture, which we refer to as informal regulation. Morale consists of personal standards to which people attempt to align their behavior (Tyler 2006b). What is morally valid is delimited through judgments or arguments that an agent formulate to him or to others about the rightness of an action.
Emotions like guilt or anticipated guilt are linked to the moral regulatory system and act as dissuasive factors to avoid morally wrong actions. In an environment where legal and moral systems are compatible, guilt or anticipated guilt have dissuasive power to avoid
1 A clear example of this kind of regulation is the “National Wastewater Discharge Fee Program”
implemented in Colombia since 1997 (see Blackman, 2009)
breaking the law. Culture is partly composed of social norms. What is culturally valid corresponds to what is socially accepted and it is, in some cases, independent of what the legal and moral regulatory system mandates. Emotions like shame or fear of social disapproval are linked to the cultural regulatory system and constitute dissuasive elements to avoid actions which are socially punished. Where there is harmony between legal, moral and cultural regulatory systems, social and internal norms enforce compliance with the law (Mockus, 1994, 2003). Tyler (2006b) also points at legitimacy of the law and of the regulator as a necessary condition for the law to be obeyed.
Legitimacy is defined by the author as a perceived obligation to authorities or existing social arrangements and because of it people feel that they ought to ought to voluntarily obey rules. According to Tyler (2006b), although legitimacy and morality are similar in many ways they are also differentiable and sometimes do not work in concert.
The question I address in the thesis is how cooperation in social dilemma situations and compliance with environmental regulations are determined by the three regulatory systems and by the legitimacy of regulations. In light of this, the thesis consists of five independent papers. The first two papers analyze compliance with the formal environmental regulation. The third paper looks at the interaction between legal, moral and cultural regulatory systems in the context of compliance with environmental laws.
The last two papers focus on the influence that the design of mechanisms such as disclosure of contributions and the background of social groups have on contributions to a public good.
The first chapter of this thesis analyzes the interaction between incomplete enforcement and technology adoption under price-based and quantity-based environmental policies. It has been recognized that different environmental policies provide different incentives for technological change which, in the long run, is considered the primary solution to environmental problems (Kneese and Schultze 1978). In this chapter we compare emission taxes and tradable emission permits in terms of: (i) how compliance changes with the use of new technologies and (ii) how technology adoption is affected by enforcement parameters such as the probability of being monitored. Our results suggest that the interactions between technology adoption and incomplete enforcement have important implications in terms of the deterrent effects of the
enforcement policies and in terms of the effect of monitoring effort on the technology adoption rate. It is shown that when taxes are used, the rate of technology adoption is not affected by enforcement strategy. In contrast, when tradable emission permits are used, the rate of adoption is an increasing function of the monitoring probability.
A significant fraction of the literature on environmental regulation has been devoted to studying how environmental policies should be enforced and how they are actually enforced. Empirical studies have shown that a suitable strategy for the regulator to deal with the budget constraints in the enforcement activity is to target enforcement (Gray and Deily 1996; Rousseau 2007). Using a conventional model of non-compliant firms in a setting of uniform taxes, in the second chapter of this thesis, I analyze the effects of a targeted enforcement strategy on the rate of technology adoption and aggregate emission level. The result suggest that, with a targeted enforcement strategy based on adoption status, a regulator might stimulate or slow down the adoption of the new technology through monitoring pressure on both types of firms when firms are non-compliant. The fact that the technology adoption rate is influenced by monitoring strategy is good news for a regulator who wants to achieve a given level of aggregate emissions but has political constraints on the level of the tax to be imposed. Such a regulator may use a differentiated monitoring strategy to induce technology adoption and therefore to reduce aggregate emissions for a given politically feasible tax level.
The third chapter of this dissertation analyzes how the interaction between legal, moral and cultural regulation systems determines compliance with tax liabilities in the context of environmental regulations with weak legal enforcement. Most standard models of enforcement and compliance with environmental regulations assume that once a violation is detected, a sanction is successfully imposed. However, in many countries, especially in developing and transitional countries, detected violators are not always sanctioned.Weak institutions for enforcing sanctions due to lack of resources, corruption and/or long, tedious and costly legal procedures are all obstacles of successful compliance (Blackman, 2009). In such a context the probability of being sanctioned does not coincide with the probability of being detected but is instead determined by the joint
probability of being monitored and being sanctioned given a detected violation of the law.
Traditional models of enforcement of law assume that the probabilities of detection and sanctioning given detection are perfect substitutes. Therefore, as long as the joint probability of detection and sanctioning is constant, the extent of violations will not change with different combinations of these two probabilities. However, agents’
compliance behavior is not only determined by risk preferences and expected costs and benefits from violating, but it is also influenced by aspects such as social norms, morality and legitimacy of the regulation (e.g. Andreoni et al., 1998;Torgler, 2002; Tyler, 2006a).
In the third chapter of this thesis we first develop a theoretical model which, in addition to legal costs takes into account moral costs, legitimacy issues and image costs faced by the agent when making compliance decisions. In contrast to the standard model of law enforcement, our theoretical model predicts that varying the probability of detection and the probability of sanction has consequences in term of violations even when the joint probability of detection and sanctioning is kept constant. Second, by using a laboratory experiment, we empirically test the predictions from our theoretical model that different combinations of the probability of detection and the probability of sanction results in different extent of violation even when the joint probability is kept constant.
We ran our experiments with both students and environmental managers of Colombian firms. The results from the sample of managers indicate that we cannot reject the hypothesis that detection and sanctioning probabilities are substitutes. However, the level of violation chosen by environmental managers is lower than the violation predicted by the standard model, indicating that there are determinants of the extent of violations additional to economic incentives. For the sample of students, the chosen level of violation is lower than the predicted violation. When analyzing differences in deterrence effect between different combinations of probabilities, we found that students violate significantly less when facing a high sanctioning given detection probably than when facing a high monitoring probability and low probability of sanctioning.
The fourth chapter of this thesis studies the effect that the design of mechanisms like disclosure has on contributions to public goods. As pointed out by Frey and Jegen
(2001) and Nyborg and Rege (2003), external interventions may enhance intrinsic motivations (crowding in) when the external intervention is perceived by subjects as supportive, or reduce intrinsic motivations (crowding out) when the intervention is perceived by subjects as controlling. In this chapter we investigate whether disclosure, as an external intervention, crowds out contributions to a public good by using an experimental approach, and more specifically, we test the effect of different degrees of disclosure on contribution levels in our public goods experiments. We present evidence indicating that the incentives provided by the three disclosure treatments increase unconditional contributions to the public good compared to the no-disclosure treatment, although the effect is not statistically significant at conventional levels. We find that, when implementing joint in-group and out-group disclosure, the proportion of subjects contributing the whole endowment significantly increases, compared to the no disclosure treatment, while the proportion of non-contributors does not change significantly. Our results also indicate that disclosure policies with larger audiences and more detailed information may induce a higher heterogeneity in cooperation behavior and that unconditional contribution may be moved in various ways. The direction in which unconditional contribution moves with joint disclosure may depend on underlying characteristics of subjects such as the importance they assign to social approval, on the degree of internalization of the norm for cooperation, and in the interpretation they make of the disclosure policy limiting the effectiveness of the policy.
Finally, in the last chapter we investigate cooperative behavior in different social groups by keeping cross- and within-country differences constant. We worked with university students recruited from two universities in Medellin, Colombia, who differed in socio-economic conditions. Our results suggest that different social groups exhibit differences both in terms of composition of types and extent of conditional cooperation.
The dominating type is conditional cooperators in both groups. Interestingly, 25 percent of the subjects in the group of high socio-economic group were classified as free riders, compared to 4 percent in the medium-low socio-economic group.
References
Andreoni, J., Erard, B., Feinstein, J., 1998. “Tax Compliance”. Journal of Economic Literature 36: 818-860.
Bénabou, R., Tirole, J., 2006. “Incentives and Prosocial behavior”. American Economic Review 96: 1652-1678.
Blackman, A. 2009. “Colombia’s discharge fee program: Incentives for pulluters or regulators?”. Journal of Environmental Management 90 (1): 101-119
Frey, B., Jegen, R., 2001. “Motivation Crowding Theory: A Survey of Empirical Evidence”. Journal of Economic Surveys 15: 589-611.
Gray W., Deily M. 1996. “Compliance and enforcement: Air pollution regulation in the American steel industry”. Journal of Environmental Economics and Management 31: 96- 111
Kneese, A. , Schultze, C.L. 1978. “Pollution, Prices, and Public Policy”. The Brookings Institute, Washington, DC .
Mockus, A. 1994. “Anfibios culturales y divorcio entre ley, moral y cultura”. Análisis Político. 21: 37-48
Mockus, A. 2003. “Legal, Moral, and Cultural Self-Bindings to Prevent Shortcuts.”
Symposium ”Constitutions, Democracy and the rule of Law”. Columbia University.
October.
Nyborg, K., Rege, M., 2003. “Does public policy crowd out private contributions to public goods?”. Public Choice 115: 397-418.
Rousseau, S. 2007. “Timing of environmental inspections: survival of the compliant”
Journal of regulatory economics. 32: 17-36
Torgler, B., 2002. “Speaking to the theorist and searching for the facts: tax morale and tax compliance in experiments”. Journal of Economic Surveys 16: 657-83.
Tyler, T.R. 2006a. ”Why people obey the law”. Princeton University Press. Princeton and Oxford. Printed in USA
Tyler, T.R., 2006b. “Psychological Perspectives on Legitimacy and Legitimation”.
Annual Review of Psychology 57, 375-400.
Chapter 1
a Department of Economics. School of Business, Economics and Law. University of Gothenburg.
Gothenburg, Sweden. E-mails: Clara.Villegas@economics.gu.se and Jessica.Coria@economics.gu.se
b Facultad de Minas. Universidad Nacional de Colombia – Sede Medellín. Medellín, Colombia. E-mail.
civillegas@unal.edu.co
c Facultad de Economía y Empresa, Universidad Diego Portales, Santiago, Chile.
** We are grateful to Carlos A. Chávez, Katrin Millock, Katarina Nordblom, Thomas Sterner and an anonymous reviewer for valuable comments and suggestions. We thank participants of the Policy Instruments course in March of 2008 at the University of Gothenburg for useful comments. We also
On the Interaction Between Imperfect Compliance and Technology Adoption: Taxes vs. Tradable Emissions Permits**
Clara Villegas-Palacio a,b Jessica Coriaa,c
Abstract
This paper analyzes the effects of the interaction between technology adoption and incomplete enforcement on the extent of violations and the rate of abatement technology adoption. We focus on price-based and quantity-based emission regulations.
First, we show that in contrast to uniform taxes, under tradable emissions permits (TEPs), the fall in permit price produced by technology adoption reduces the benefits of violating the environmental regulation at the margin and leads firms to modify their compliance behavior. Moreover, when TEPs are used, the deterrent effect of the monitoring effort is reinforced by the effect that technology adoption has on the extent of violations. Second, we show that the regulator may speed up the diffusion of new technologies by increasing the stringency of the enforcement strategy in the case of TEPs while in the case of uniform taxes, the rate of adoption does not depend on the enforcement parameters.
Key words: technological adoption, environmental policy, imperfect compliance, enforcement.
JEL classifications: L51, Q55, K32, K42.
1. Introduction
In the long run, technological change is considered the primary solution to environmental problems (Kneese and Schultze 1978), and it has long been recognized that environmental policy creates incentives that affect the process of technological development (Jaffe et al. 2002; Requate 2005). Many scholars have therefore analyzed how alternative policy instruments affect the rate and direction of technological change.
Among market-based policies, the analyses tend to support the use of emission taxes (price-based regulation) over tradable emission permits (TEPs) (quantity-based regulation), when the regulator is myopic and does not adjust the level of the policy in response to the advent of new technology.1 The fact that the emission price is fixed under the tax while it decreases under permits creates a wedge between the two instruments and between the rates of adoption they induce.
Previous analyses of technology adoption under different policies share a common and implicit assumption: Firms perfectly comply with environmental regulations.
However, reality generally differs from this assumption. In some cases, a fraction of firms do not comply with an environmental regulation and furthermore, the expected enforcement costs can be substantial. The intuition of the interaction between incomplete enforcement and technology adoption can be thought of in two ways: (1) incomplete enforcement, and therefore the possibility that firms do not comply with a regulation, may influence the profits of firms from technology adoption and thus the adoption decision, and (2) the existence of a new technology that reduces the abatement costs may influence a firm’s compliance decisions since the marginal benefit of violations is reduced.
The purpose of the present paper is to analyze the interaction between incomplete enforcement and technology adoption under price-based and quantity-based policies. We compare emission taxes and TEPs in terms of: (i) how compliance changes with the use
1 See Milliman and Prince 1989; Jung, Krutilla, and Boyd 1996; Kennedy and Laplante 1999; Requate and Unold 2001; and Requate and Unold 2003 for comparison of incentives provided by environmental policies.
of new technologies and (ii) how technology adoption is affected by enforcement parameters such as the probability of being monitored.
To our knowledge, the interaction between technology adoption and imperfect compliance and its effects on the comparison between uniform taxes and tradable permits has not yet been directly addressed. Some literature has been devoted to comparing policy instruments when incomplete enforcement is an issue (Montero 2002; Rousseau and Proost 2005; Macho-Stadler 2008), but no previous study considers the interaction between an enforcement policy and technology adoption, which is the objective of the present paper. 2
To analyze the links between technology adoption and imperfect compliance, we model a competitive industry consisting of a continuum of firms that are subject to environmental regulation that could take the form of either emissions taxes or auctioned tradable permits. Before the arrival of new abatement technology, the firms' abatement costs are homogeneous. When the new technology becomes available, each firm can independently decide to invest or not invest in a new technology that shifts the firm's abatement cost function downwards at the expense of a fixed cost. The adoption decision is made based on the comparison of the expected costs of abatement and compliance under the current and the new technology. For simplicity, we focus on the analysis of interior solutions, i.e., firms provide positive reports of their emissions under taxes and hold a number of permits higher than zero under a scheme of TEPs.
Our results suggest that the interactions between technology adoption and incomplete enforcement have important implications in terms of the deterrence effect of the enforcement policies and in terms of the effect of monitoring effort on the technology adoption rate.
2 The ranking of priced-based versus quantity-based environmental regulation was first studied by Weitzman (1974), who analyzed the choice between these two types of instruments when there is uncertainty. After Weitzman (1974), the comparison between price- and quantity-based policies has been further developed (Roberts and Spence 1976; Yohe 1978; Finkelshtain and Kislev 1997; Hoel and Karp 2002; Montero 2002; Moledina et al. 2003; Baldursson and von der Fehr 2004; Quirion 2004;
Stranlund and Ben-Haim, 2008).
It is shown that when taxes are used, the rate of technology adoption is not affected by enforcement strategy. In contrast, when TEPs are used, the rate of adoption is an increasing function of the monitoring probability. Additionally, under TEPs, for a given monitoring probability, the fall in permit price produced by technology adoption reduces the benefits of violating the environmental regulation at the margin and ultimately leads both adopters and non-adopters to modify their compliance behavior.
This is not the case under emissions taxes where the tax rate remains unchanged after technology adoption. Thus, in contrast to taxes, the extent of violations under TEPs decreases with the rate of adoption. Moreover, when TEPs are used, the deterrent effect of the monitoring effort is reinforced by the effect that technology adoption has on the extent of violations. These results constitute good news for a regulator who, by choosing TEPs, may be able to obtain a higher reduction in the extent of violation due to the availability of new technologies. Also, the regulator may be able to use monitoring effort as a tool influence the diffusion of new abatement technologies.
The paper is organized as follows. Section II presents the model of adoption, and Section III introduces the compliance analysis under emission taxes and TEPs. Section IV explores the way in which the rate of technology adoption is affected by the enforcement strategy under both policy instruments, and how the influence of monitoring probability on technology adoption reinforces the effect of the former on the extent of violations under TEPs. Finally, Section V offers a discussion of the policy implications of our results and concludes the paper.
2. The model
We consider a competitive industry consisting of a continuum of firms Λ⊂[0,1]
that are risk-neutral. In the absence of environmental regulation, each firm emits a quantity e0 of a homogeneous pollutant. We assume there is an environmental authority that sets an environmental target – a maximum level of emissions – and then chooses a policy instrument to reach this target. Since the regulator cannot observe firms’
emissions, costly monitoring is undertaken. In our model, the regulator has a fixed
monitoring budget given by B, and the cost of an audit to a firm is given by w. The ratio between the number of possible audits given the regulator’s budget (
w
B) and the size of
the continuum of firms defines the probability of being monitored, , which is known by firms. Once the regulator monitors a firm, it is able to perfectly determine the firm’s compliance status. If the monitoring reveals that the firm is non-compliant, it faces the penalty F(v), where v represents the extent of the violation. This is a strictly convex function of the extent of violation: F'(v)0;F''(0).3 For zero violation, the penalty is zero F(0)=0, but the marginal penalty is greater than zero: F’(0)>0.
Firms can reduce emissions through the current abatement technology. As Requate and Unold (2003), we assume that initially all firms are alike in abatement costs,
) (e
c . We assume that c(e) is strictly convex and decreasing in emissions:
0 ) ( ''
; 0 ) (
'e c e
c . A new and more efficient technology arrives and firms must decide whether or not to invest in it. The new technology allows firms to abate emissions at a lower cost, given by c e( ), where
0,1 is a parameter that represents the drop in abatement cost due to adoption of the new technology. As in Requate and Unold (2003), technology adoption implies a lower marginal abatement cost curvee0
e all for ) ( ' ) (
'
c e c e .4
3 Stranlund et al. 2009 mention some authors who assume that the penalty function is strictly convex:
Harford 1978, 1987; Sandmo 2002; and Macho-Stadler and Perez Castrillo 2006. Stanlund et al. 2009 assume a linear penalty function in their model, an assumption that is not common in the literature. If the probability of being monitored is exogenous and the marginal penalty is constant, the decision on reporting emissions will be of the type reporting everything or reporting nothing (see Sandmo 2002 and Heyes 2000).
4 To keep the analysis mathematically tractable and simple, we assume that firms are homogeneous in terms of current abatement costs. Nevertheless, our results still hold in the case of heterogeneous abatement. For example, following Coria 2009, we could have assumed that firms’ current abatement costs are heterogeneous and that firms can be ordered according to their adoption savings from the firm with the highest to the firm with the lowest current abatement cost. Therefore, the arbitrage condition that states that the adoption savings for the marginal adopter offset the adoption costs still holds. In such a setting, and as is shown later, adopters will increase their abatement effort due to the availability of the new technology and will reduce their demands for emissions.
We assume that buying and installing the new technology implies a fixed cost that differs among firms.5 Let ki denote the fixed cost of adoption for firm i, wherekiis uniformly distributed on the interval(k,k). Let NAi and Ai be firm i’s total expected costs of abatement and compliance when using the current abatement technology (non- adoption) and new technology (adoption), respectively, such that the expected cost saving from adopting is NAiAi. Any firm whose expected cost saving offsets its adoption cost will adopt the new technology6. In the continuum of firms Λ⊂[0,1], the marginal adopter is then identified by the arbitrage conditionk~i NAiAi
. Hence, following Coria (2009b), the rate of firms λ ∈ [0,1] adopting the new technology is defined by the integral
(1) ~) ( ) ( ) (0,1)
( ) (
~
k NAi Ai NAi Ai NAi Ai
k
i
i k k
F k k F dk k f
i
where the right-hand side follows from the definition of the uniform cumulative distribution of ki ~U(k,k), 1
k k
and k.
From equation (1), it is straightforward that the adoption rate depends on the total expected savings in the costs of abatement and compliance, which are endogenous to the choice of policy instrument, the stringency of the environmental policy, and the enforcement policy.
5 The assumption that adoption costs differ among firms is not new in the literature analyzing the effects of the choice of policy instruments on the rate of adoption of new technologies. See, e.g., Requate and Unold (2001). On the other hand, Stoneman and Ireland (1983) point out that although the majority of the theoretical and empirical literature on technological adoption concentrates on the demand side alone, supply-side forces might be very important for explaining patterns of adoption in practice. Thus, for example, costs of acquiring new technology might vary among firms according to firm characteristics, e.g., location or output, or because of competition among suppliers of capital goods.
6We assume that firms minimize their costs for any level of output, but do not treat the output decision explicitly.
In the next section, we analyze the firms’ compliance behavior when environmental regulation takes the form of a uniform emission tax or TEPs. It is sufficient to keep track of the marginal adopter’s optimal choices of emissions and report in order to derive the rate of adoption; therefore the subscript i is hereinafter omitted.
3. Compliance behavior and technological adoption
In a uniform emission tax system, firms are required to self-report their emissions.
A firm is non-compliant if it attempts to evade some part of its tax responsibilities by reporting an emission level that is lower than the true level. In the case of a regulation using permits, a firm should hold one permit for each unit of emissions. A firm that in equilibrium holds fewer permits than its emissions is a non-compliant firm.
The interaction between the regulator and firms is described by the following two- stage mechanism:
Stage 1. The regulator sets the environmental target before the arrival of the new technology and chooses a policy instrument to reach it. We assume that the regulator does not modify the level of the environmental policy in response to the availability of the new technology. The enforcement strategy is exogenously determined and consists of a probability of being monitored and a sanctioning scheme. The enforcement strategy is set regardless of the regulatory scheme selected by the environmental authority; i.e., firms face the same enforcement policy regardless of policy instrument. This assumption does not contradict reality since, in many cases, the institutional arrangements separate the design of the regulatory instrument from the design of enforcement strategies.
Stage 2. Firms make compliance and adoption decisions. The adoption decision is made based on the comparison of the expected costs of abatement and compliance under the current and the new technology.
Let us now analyze the extent of violation of both adopter and non-adopter firms when regulated by either uniform emission taxes or TEPs.
Uniform Emission Tax
Let us assume that firms must pay a uniform tax t per unit of pollutant emitted and that they self-report their emissions. If a firm reports truthfully, the total amount of taxes to be paid is te. Since there is incomplete enforcement, the firm could try to evade a fraction of its tax payment by reporting a lower level of emissions. If the firm reports emissions equal to r , where re, then the total tax payment is given by tr. In this case, the firm’s violation equals the difference between the actual emissions and reported emissions, vieiri. If the firm is caught in violation, a penalty is imposed according to the penalty function explained above.
Adopters select the emissions and report levels that minimize their expected costs of abatement and compliance:7
(2) Mine,rc(e)trF(er), s.t. er0.
Note that the constraint in the optimization problem reflects the fact that there are no economic incentives to over-report emission levels.8 Solving this minimization problem, if the solution is interior, a firm’s choice of emission is given by c e'( ) t 0. Each firm chooses its emission levels such that the marginal abatement cost equals the tax rate. The emission levels for adopters and non-adopters are, respectively,
(3) e tA( )
e c e '( ) t 0
; eNA(t)
ec'(e)t0
.Since there is a uniform tax rate, in equilibrium firms’ marginal abatement costs are equal irrespective of their adoption status: c e'( NA)c e'( )A . Since
0,1 , it isnecessary that c'(eNA)c'(eA), which is only possible, given the properties of the abatement cost function, if eNAeA. Therefore, adopters’ actual levels of emissions are reduced due to the availability of the new technology and - in this setting- are lower than
7The problem of the firms that do not adopt the new abatement technology is analogous to problem (2); the main difference is that the abatement costs for these kinds of firms are given by c e( ) instead
of c(e).
8 We have omitted the calculations of the optimization problem (available upon request).
those of non-adopters.9 In addition, in line with previous literature analyzing the compliance behavior of firms under imperfectly enforceable taxes, we find that since the tax is exogenous and not influenced by the enforcement strategy, firms’ actual emissions do not depend on the parameters of the enforcement problem (e.g., Harford 1978).
However, this result only holds when the monitoring probability is high enough to guarantee more than zero reported emissions. When firms report zero emissions, the level of emissions is decreasing in monitoring probability (see Macho-Stadler and Pérez- Castrillo 2006 for detailed analyses of corner solutions).
Let us now look at a firm’s emission report and extent of violation. When the firm is noncompliant, then er0, which from the Kuhn Tucker conditions for (2) implies that tF'(er)0. The report levels of adopter and non-adopter firms are, respectively,
(4) r tA( , , ) F
r tF e'( ArA)0
; rN A( , , )t F
r tF e'( NArNA)0
. The equations in (4) state that firms choose to report a level of emissions such that the marginal expected fine equals the marginal benefit of non-compliance, i.e., the tax.Combining both equations, we obtain eArAeNArNA. Note that rNArA since eNA eA. Hence, the emissions reported by adopters are lower than those reported by non-adopters.
Working on comparative statics, it is possible to show that the report levels of adopter and non-adopter firms are decreasing in the tax rate and increasing in the monitoring probability (see proof in Appendix A). This result is in line with previous findings in the literature on TEPs (see Stranlund and Dhanda 1999).
Proposition 1: With uniform taxes, the extent of violation of firms is independent of the adoption status and is therefore the same for adopters and non-adopters of the new technology.
9 The fact that adopters’ emissions are lower than non-adopters emissions is mainly due to the new technology being the most efficient alternative available. Indeed, adoption shifts every firm's abatement cost function downwards at the expense of a fixed cost. The introduction of some heterogeneity in the current abatement costs might imply that some firms do not obtain significant savings from adopting.
However, it might still imply a lower level of emissions by non-adopters if no current technology is more
Proof 1: The extent of a violation is given by v(t,,F)e(t)r(t,,F). From equation (4), we obtain that F'(eArA)F'(eNArNA), and since the enforcement strategy is exogenously set and independent of the adoption status, it is straightforward to observe
that eArAeNArNA. Q.E.D.
The intuition behind this result is as follows. On one hand, since the enforcement strategy does not depend on adoption status, the expected marginal cost of evasion does not change with adoption. On the other hand, the marginal benefit of violation does not depend on adoption status either, since it is given by the unit tax rate. Therefore, given that the marginal benefits and expected marginal costs of disobeying the law are the same for all firms, the extent of the violation is the same regardless of adoption status.
Tradable Emissions Permits
A firm regulated by TEPs can abate a fraction of its emissions and buy permits to compensate for the remaining fraction. The equilibrium price of each permit is represented by p , and a firm that emits e should spend pe on buying permits. Assume that the authority issues L emission permits each period and that the possession of a permit gives the legal right to emit one unit of pollutant. In the presence of imperfect compliance, polluters have an incentive to hold in equilibrium a quantity of permits lower than e to reduce their expenditure on permits. Let l denote the quantity of permits held by a firm in equilibrium and l0 be the number of emissions permits initially allocated to it. A firm is non-compliant if after trade it holds a number of permits that is lower than its corresponding units of emissions. The extent of violation is then given by v e l . We assume that the enforcement authority keeps perfect track of each firm’s permit holding.10 Adopters select the emission level and demand for permits that minimize total expected costs:
10 Assume, for instance, that all transactions performed in the market have to be registered with the authority. Since the authority has information about initial allocation, it is able to have perfect information about each firm’s permit holding at any point in time.
(5) Mine l,c e( )p l
l0
F e l( ), s.t. el0.From the solution to the optimization problem, if the solution is interior, the emissions levels for adopters and non-adopters are, respectively,
(6) e pA( )
e c e '( ) p 0
; eNA(p)
ec'(e)p0
.The equations in (6) state that in equilibrium each firm chooses its emissions such that the marginal abatement cost equals the equilibrium permit price, which is the same for all firms regardless of adoption status. Since the adopters’ marginal abatement cost is lower than that of the non-adopters, eNA( )p eA( )p . The number of permits held by adopters and non-adopters is, respectively,
(7) lA( , , )p F
l pF e'( AlA)0
, lN A( , , )p F
l pF e'( NAlNA)0
. The equations in (7) show that in equilibrium, firms hold a quantity of permits such that the marginal expected fine equals the marginal benefit of non-compliance, i.e., the equilibrium permit price. Since the permit price and the enforcement strategies faced by adopters and non-adopters are the same, we obtain that eA lA eNAlNA. Given thatA
NA e
e , it follows that lNAlA for the equality to hold. Therefore, with TEPs, the actual emissions and the quantity of permits that firms hold in equilibrium are reduced following adoption and are lower than the actual emissions and the quantity of permits held by non-adopters in equilibrium.11
Proposition 2: With TEPs, a firm’s extent of violation is independent of its adoption status and is therefore the same for adopters and non-adopters of the new technology. However, for a given monitoring probability, the extent of violation is decreasing in the rate of adoption.
11 Analogous to the tax case, the introduction of some heterogeneity in current abatement costs might imply that adopters hold more permits than non-adopters if the new technology is not more efficient than all the current technologies available. However, the main results in this section remain the same since both adopters and non-adopters improve their compliance behavior due to the drop in equilibrium permit price
Proof 2: The extent of violation of a firm is determined by the arbitrage condition '( )
F v p
. Since the equilibrium permit price and the enforcement strategies faced by adopters and non-adopters are the same, we obtain that the extent of violation is the same regardless of adoption status, eA lA eNAlNA. The fact that changes in abatement cost parameters do not affect the extent of violation as long as the enforcement strategy and the permit price remain the same is well known in the literature (see, e.g., Stranlund and Dhanda 1999 and Chávez et al. 2009). However, the adoption rate affects the extent of violation of adopters and non-adopters via the equilibrium permit price and hence the extent of the violation of adopters and non-adopters:
P
P v
v .
Violations are an increasing function of permit price, 0
P
v 12
. The sign of
v
therefore depends on the sign of
P. To determine the influence of the adoption rate on
the equilibrium permit price
P, consider the market equilibrium equation. The permit
price that clears the market is given by the equilibrium between supply and total demand for permits:
(8) LlA(p(,))
1
lNA(p(,)).Taking the total derivative of equation (8) with respect to the technology adoption rate – and given that the supply of permits is fixed – we observe in equation (9) that an increase in reduces the equilibrium permit price due to the fact that adoption decreases adopters’ demand for permits and consequently the aggregate demand in
lAlNA
. This reduction in aggregate demand pushes the permit price down.
12 Taking the total derivative of PF' v( )with respect to price, it is easy to derive
) ( '' 1 v F P
v
, which, given the properties of the penalty function, is positive (see Stranlund and Dhanda 1999).
(9)
. 0 )
1 (
P l P
l l l P
NA A
NA A
Given that the permit price decreases with the rate of technology adoption ( 0
P ) and
that a drop in permit price implies a reduction in the extent of violations, it follows that for a given monitoring probability, violations are decreasing in the rate of adoption.
Q.E.D
Therefore, technology adoption does provide incentives to improve compliance when firms are regulated by TEPs. This is an important difference between uniform taxes and TEPs, which relates to the assumption that the regulator does not respond to the advent of a new technology by changing the level of the environmental policies or the enforcement strategy. If the regulator instead adjusts the level of the tax and the cap on emissions before adoption takes place, the adoption incentives provided by the policies will coincide (Requate and Unold 2003; Coria 2009), as will the compliance incentives.
Note from equation (8) that the equilibrium permit price is linked not only to the adoption rate but also to the monitoring probability, . Changes in the monitoring effort might therefore affect the rate of technology adoption and hence the extent of violation.
4. Monitoring probability and effects on technology adoption As stated in the beginning of the present paper, the rate of adoption is determined by the difference between the expected costs of abatement and compliance under the current and the new technology. For the case of uniform taxes, these costs are expressed as:
(10) A( , ,t F)c e t( ( ))A tr tA( , , F)F e t( ( )A r tA( , , F)), (11) NA( , ,t F)c e( NA( ))t trNA( , ,t F)F e( NA( )t rNA( , ,t F)).
